3 Warning Signs the Biotech Rally May Be Over

The biotech sector has been creamed over the past couple of sessions. Have you been ignoring these three biotech bubble warning signs?

Yes, despite contrary belief, biotech stocks can actually go down just as they've been going up, and up, and up some more over the past couple of years.

Friday's tumble in the SPDR S&P Biotech ETF on the heels of congressional probing into the pricing practices of select drugs, including Gilead Sciences' Sovaldi, which amounts to a cost of $84,000 per year, set off a chain reaction that brought high-flying biotech stocks of all market caps to the deck. Over just the past four trading sessions, the SPDR S&P Biotech ETF has lost a whopping 9.3% of its value -- and this could be just the beginning.

We've been given plenty of warning signs for months that a sizable correction could be in the offing in the biotech sector, but investors have largely ignored those warnings. Now it appears a biotech correction could be rearing its head. Here are what I believe to be three reasons the biotech rally may be over.

1. Post-IPO valuations make little sense.We needn't look very far for a reason to scratch our heads if we more closely examine biotech IPOs over the past year.

In 2013, there were 38 total biotech IPOs with the group gaining an average of 43% for the year! Some have deserved their beefy gains, such as Five Prime Therapeutics, which just last week signed a collaborative deal with Bristol-Myers Squibb allowing the big pharma giant to access its exclusive immune-oncology platform in exchange for $20 million in upfront cash, $9.5 million in research funding, a $21 million common equity investment, and as much as $300 million in development milestone payments.

Many, though, made less sense. Take Prothena(NASDAQ:PRTA), which debuted in late Dec. 2012 and has proceeded to barrel from as low as $5.84 per share to more than $49 intraday last week. Prothena has delivered some exciting developments, including licensing its preclinical Parkinson's disease drug to Roche for $45 million. But, it ultimately has just one clinical phase study ongoing with systemic amyloidosis drug NEOD001, and even that's just in phase 1. Added up, that's two preclinical studies and one phase 1 study currently ongoing, yet Prothena ended last week with a valuation of $1 billion. To me, that makes very little sense!

2. Acquisition valuations are also reaching. In addition to frothy-priced IPOs, big pharma has been reaching more and more to find growth opportunities both domestically and overseas. Knowing this all too well, small- and mid-cap biotechs are demanding hefty premiums from big pharma, and getting them!

There have been numerous reaches in the past year, but none stand out more than Perrigo's (NYSE:PRGO) purchase of Elan and Actavis' (NYSE:AGN) recent purchase of Forest Laboratories(NYSE:FRX).

On the surface, I completely get why Perrigo purchased Elan for $8.6 billion last year -- it wanted to incorporate in Ireland and take advantage of considerably lower corporate tax rates there, which would allow it to add to its profits. But, Perrigo paid an enormous premium for a shell of a company that had essentially sold its only marketable therapy for $3.25 billion in cash to Biogen Idec, and that didn't have much going on in its pipeline to begin with. The way I look at it, Perrigo gave up $2 to get $1 plus tax breaks in return.

Something similar can be said for Actavis, which agreed to acquire Forest Labs for a hefty $25 billion in a cash and stock deal. Based on Forest's current product portfolio, the deal might make a shred of sense, but given that the patent of its Alzheimer's disease drug Namenda, which accounted for close to half its total revenue in the latest quarter, is set to expire in 2015, the deal has all the makings of "cross your fingers and hope for the best."

M&A activity is bullish in that it signifies a business' willingness to take on risk, but I think that the risk being absorbed by acquiring companies is simply too large to ignore anymore.

3. Investors are counting their chickens before they've hatched.Perhaps no company has been a better poster child for this than Intercept Pharmaceuticals(NASDAQ:ICPT). Shares of Intercept have leapt 437% since the year began, following the release of phase 2 data from its FLINT trial involving obeticholic acid (OCA), a therapy for nonalcoholic steatohepatitis (NASH), which is a liver disease that can result in cirrhosis or liver cancer, that was stopped early by an independent data monitoring committee for highly statistically significant efficacy. Because some six million people in the U.S. may have a severe form of this debilitating condition, the moat of opportunity for Intercept is huge. Adding to OCA's recent fame, its phase 3 POISE trial for the treatment of biliary cirrhosis of the liver also hit its primary endpoint last week.

However, investors are placing a lot of faith in OCA -- a $7.2 billion market valuation, to be exact -- despite ongoing questions about the long-term safety of the drug, which independent researchers are currently reviewing. What I find even more mindboggling is that we don't even have the full data set from the FLINT trial yet! It isn't even scheduled to be released by Intercept until July. So while investors ponder OCA's blockbuster status, we're not even sure how effective and safe the therapy actually is.

These biotech bubble warning signs have been evident for months; now it just remains to be seen if this dip over the past couple of days turns into a full-blown correction, or if we again shake off these warning signs and head higher.

Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

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A Fool since 2010, and a graduate from UC San Diego with a B.A. in Economics, Sean specializes in the healthcare sector and investment planning. You'll often find him writing about Obamacare, marijuana, drug and device development, Social Security, taxes, retirement issues and general macroeconomic topics of interest. Follow @TMFUltraLong